What to do in a world of rising volatility

Kirk Spano, the winner of the first MarketWatch competition
to find the world’s next great investing columnist, is a registered investment
advisor and founder of Bluemound
Asset Management, LLC which seeks to provide investors with greater safety,
growth, income and freedom. Kirk’s biography and various business endeavors can
be found at KirkSpano.com. Follow Kirk on
Twitter @KirkSpano or at the
Bluemound Facebook page for his columns, company analysis, letters, trade
notes and what he is reading.

"Volatility is a symptom that people have no idea of the underlying value.” Jeremy Grantham

Since the Flash Crash of 2010 and the wild swings of 2011, stock-market volatility has generally drifted downward the past three years. In 2014, as measured by the CBOE Volatility Index (VIX), we've seen one of the most subdued markets in a long time. In July, volatility hit the lowest levels since before the financial crisis.

According to Grantham, the decrease in volatility would imply that investors have generally felt very comfortable with their evaluations of what stock-market assets are worth. With the end of quantitative easing (QE) by the Fed, though those assessments will likely become less certain and volatility will increase.

As I've written about on MarketWatch and at my website, one of the key drivers to the gains in the stock market the past few years has been the Fed's printing of money. This is a view shared by quite a few people, including Federal Reserve Chair Janet Yellen, who in her confirmation testimony mentioned the benefit of QE on people's 401(k) balances. One of the direct impacts of QE was to erode the value of the dollar, making asset prices higher, as it took more dollars to buy things.

With less money printing this year as the Fed tapered QE, we have recently seen the dollar gain back some strength. Next month, as confirmed at the last Fed meeting, QE will end. Combined with America's positive emerging energy picture, I expect the dollar to at least remain firm and possibly drift higher in coming years. The stronger dollar should last through the next recession or global crisis. The result during this time frame, which I estimate to be one to three years, implies less appreciation of many asset prices or outright declines.

If the scenario plays out as I think it will, many investors are likely to become less certain of the value of their assets, leading to more volatility. Currently, investor sentiment is very high, however, if what I am hearing is a good sampling, there is still an underlying current of negativity about the nation's economics and finances. When the switch is flicked, and those negative sentiments come to the fore, I think we are likely to see volatility increase quickly and significantly. That could very well trigger the correction that many of us have thought was inevitable since last year.

What to do now

As most readers who have followed me know, I am not an advocate of frequent trading, however, from time to time, a significant asset allocation shift is warranted. Now seems to be one of those times. Most investors who have been heavily invested in the stock and bond markets should be accumulating cash right now.

Selectively selling stocks with stretched valuations is clearly a smart idea as momentum has already slowed. Many stock funds should also be sold as broader market valuations, especially in certain sectors like utilities, are generous and likely to be less generous in a firmer dollar environment.

Bonds are a more difficult sell for most people because they falsely believe there is automatically less risk in bonds. That's not true. When interest rates are low, as they are now, and the Federal Reserve is signaling a less-friendly policy, there is risk, especially in bond funds and for bonds that you don't intend to hold to maturity. Because the economy is still soft, and in my opinion, likely to remain soft for most or all of the decade, I don't see large interest-rate increases anytime soon. Ben Bernanke was quoted as saying he wouldn't see "normal" interest rates again in his lifetime. That might be overstating it, however, it makes his point very clearly. I think shortening duration and improving bond quality are the first step bond investors should make. Longer-duration and higher-risk bonds, i.e., high yield or junk, should be pared back significantly or all the way.

The above stock and bond advice applies to both general investment accounts such as IRAs, as well as, 401(k) plans. For my Retirement Plan Monitor service, I have recently recommended that a moderate investor, generally somebody within 15 years of retirement and not particularly aggressive in general, reduce their stock fund exposure to 50%, with 25% in a short-term bond fund and 25% in a stable value or money-market fund within their 401(k). A more conservative investor, say somebody closer to retirement, can flip the stock fund and stable value/money market allocations.

What will stop most people from making these sorts of changes will be the fear of "missing it" on the upside. Once again, and remember I told people to be very heavily in stocks in 2012 and 2013, I now urge people to use caution at least through the next correction. After that correction happens, be ready to become more aggressive again.

Disclosure: Kirk and certain clients of Bluemound Asset Management own VXX shares. Neither Kirk nor Bluemound clients plan any transactions in the next three trading days. Opinions subject to change at any time without notice.

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